Distribution Dilemma in Times of Tax Uncertainty

Recently, I was speaking with a top executive at a decent-sized company. The discussion had much to do with his total compensation, but paramount in his mind was his distribution from his nonqualified defined benefit plan (SERP). You see, due to Code Section 409A and its ties that bind, executives with meaningful amounts of deferred compensation are stuck in a guessing game (more about that later).

409A was added to the Code by the American Jobs Creation Act of 2004 (a misnomer if there has ever been one). It came to be in the wake of the Enron and WorldCom scandals and was put in place to ensure that plans typically limited to management and executives would provide participants with treatment that was no better than that available to participants in qualified plans. For purposes of this discussion, paramount among the restrictions on nonqualified deferred compensation intended to achieve these goals were these (simplifying somewhat):

• Prior to the year in which compensation is deferred, participants must elect both the timing and form of their distribution.
• To the extent that participant wishes to changes his distribution option(s) with respect to money already deferred, he must make that change at least one year prior to the date that distribution would have occurred, AND postpone that distribution by at least 5 years.
• Failure to comply results in significant penalties.

Consider this scenario. You were fortunate enough to be a participant in a SERP. Then, 409A came along and you had to make your "initial deferral election" in that SERP. You didn't know what to do, but you sure liked the idea of the security and favorable conditions underlying a lump sum distribution. Your fellow executives did as well.

That was prior to late 2007. The economy was booming. Smart money was saying that Bush Era tax cuts (put in place by EGTRRA in 2001, but set to expire by the end of 2012) would certainly be extended.

Oops, wrong guess.

There's no way to be sure what's going to happen to the tax rates for the highest earners. But, there is certainly a good possibility that they are going to increase. And, there might be surtaxes for those with
ultra-high (undefined term, but you know what I am talking about) income in any given year. And, you as this executive expecting a lump sum distribution from your SERP would no doubt realize how hard you were going to get hit by this.

What's going through your mind if you remember having made your initial deferral election is that perhaps you should have made a different one. Who knew? Did you think about it that carefully?

I took a highly unscientific poll of people currently in plans subject to 409A. I asked them about their initial deferral elections. Had we been in person rather than over the phone, I expect that I would have gotten funny looks had I used that specific term. But, over the phone, I was able to explain and not see the looks in their eyes. In any event, here are the results of that poll:

• 11 of the 15 had no say in their initial deferral election; it was foist upon them by HR who said that they had made their decision for them based on legal and or accounting advice.
• 9 of the 15 didn't know what the rules were around changes.
• 13 of the 15 have a DB and or DC SERP in which they are scheduled to take a lump sum distribution.
• Given the current economic and tax climate, of those 13, 12 would like to take a different form of distribution.
• Of those 12, 11 said that back when they made their 409A initial deferral election, had they truly understood what they were doing, they would have made a different initial deferral election.

Choosing that distribution option well in advance sure does create a dilemma. There are certainly options, but more people than not don't seem to understand this.